Canadian bank stocks have seldom looked this enticing

A Royal Bank of Canada (RBC) logo is seen on Bay Street in the heart of the financial district in Toronto, Ont., on Jan. 22, 2015.

MARK BLINCH/REUTERS

Add Canadian banks to the long list of stocks that delivered dismal returns in 2018. But some encouraging developments have emerged from the sell-off: Valuations are low and dividend yields have risen to 4.6 per cent on average, pointing to a good buying opportunity right now.

First, let’s recap what happened in 2018.

The Big Six bank stocks fell by an average of 12 per cent (not including dividends). Or, if you look at the S&P/TSX Composite Diversified Banks industry group, which tracks all six banks but weights them according to market capitalization, the bank stocks fell 11.2 per cent last year.

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The group delivered strong profit growth of 13 per cent, year-over-year. And the banks hiked their quarterly dividends by an average of 7.9 per cent, continuing an impressive clip.

Canadian Imperial Bank of Commerce was the weakest of the Big Six banks, declining 17 per cent as concerns persisted about the Canadian economy and housing market, and pushing aside Bank of Nova Scotia as the year’s lagging bank stock after CIBC took a particularly sharp downturn in December.

Toronto-Dominion Bank was the best performer, but nonetheless declined 7.9 per cent. Royal Bank of Canada was a close second, with a decline of 9 per cent.

Falling share prices and rising profits translate into tempting valuations, though. According to research from RBC Dominion Securities, the Big Six trade at nine times estimated 2019 profits. That’s a bargain next to the 10-year average price-to-earnings ratio of 11.1. CIBC, the hardest-hit bank stock in 2018, trades at a mere eight times estimated profit.

Dividends are also enticing. The Big Six yield an average of 4.6 per cent, led by CIBC at 5.3 per cent. That’s hard to ignore when the yield on the Government of Canada five-year bond is back below 1.9 per cent.

There are various ways to approach the bank sector, but nothing really worked in 2018.

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The strategy of buying the prior year’s worst-performer – Bank of Montreal for 2018 – outperformed the sector by one percentage point last year, which is okay if you ignore the fact that BMO fell 11.3 per cent. (For this strategy, we use returns from the biggest five banks, which declined an average of 12.3 per cent last year). Let’s hope that CIBC, the pick for 2019 using the laggard strategy, performs better this year.

Exchange-traded funds that focus on the Big Six provide instant diversification and regular rebalancing for a relatively modest fee. Unfortunately, these ETFs failed to deliver sector-beating returns last year.

The BMO Equal Weight Banks Index ETF (ticker ZEB) holds all six bank stocks in equal amounts and rebalances regularly. This means that if one bank stock lags the others, the ETF manager will buy it in order to maintain the right balance. It also means National Bank of Canada has the same weighting as giant Royal Bank of Canada.

The ETF declined 11.8 per cent in 2018. That’s in line with the 12-per-cent average decline for the Big Six, but slightly worse than the 11.2 per cent decline for the S&P/TSX Composite Diversified Banks industry group.

The RBC Canadian Bank Yield Index ETF (RBNK) weights the Big Six banks according to their dividend yields – the two highest-yielding stocks each receive a 25-per-cent weighting, followed by a 16.7 per cent weighting for the next two stocks and an 8.3 per cent weighting for the last two stocks.

That’s an appealing approach for dividend-loving investors. However, the ETF declined 12.5 per cent in 2018. Dividends ease the pain, but not enough to make the fund a winner.

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Discouraged? Don’t be. Canadian big bank stocks have a remarkable track record of rebounding from sell-offs. Whether you invest in one stock or a basket of stocks, cheap valuations should work in your favour in 2019 – and you’ll be collecting a handsome dividend while you wait for the rally.

Tickers mentioned in this story

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